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Banks err by confusing risk, uncertainty

Complex prediction models may have blinded financial institutions to looming meltdown

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11:13am, October 8, 2012
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WASHINGTON — Major banks conduct an annual ritual of financial forecasting futility: Their complex risk models consistently flub predictions about the relative values of the dollar and the euro in the coming year, a new analysis finds.

Annual forecasts of currency values from December 2001 to December 2010, which guided banks’ investment decisions, badly missed the mark nine out of 10 times, says psychologist Gerd Gigerenzer of the Max Planck Institute for Human Development in Berlin. Banks incorrectly foretold the fates of the dollar and the euro in the years leading up to, during and after the recent financial crisis.

Gigerenzer described his findings October 4 at “Reckoning with the Risk of Catastrophe,” a meeting of German and U.S. scientists trying to devise ways to measure the probability of financial calamities, natural disasters and other catastrophes.

It’s hard to predict currency values worse than the banks did,” Gigerenzer said. “Highly paid people produced worthless predictions.”

The problem, Gigerenzer asserted, is that most economists and other risk modelers don’t distinguish between risk and uncertainty. Economic models assume that the financial world consists of known risks that can be calculated based on prior behavior of stock markets and other elements of the monetary system. But uncertainty rules in the real financial world, where risks can’t be known in advance because a complex tangle of factors triggers new, extremely unlikely hazards.

In an uncertain environment, the past is an untrustworthy guide to the future.

Financial predictions based on calculations of allegedly known risks underestimate the possibility of downturns caused by unlikely events. Banks welcome that flaw, Gigerenzer asserted, because it provides mathematical cover for pursuing high-risk investments.

“Confusing risk with uncertainty was one of the causes of the financial crisis,” he said.

Gigerenzer obtained data on annual currency forecasts of 22 international banks, including J.P. Morgan, Bank of England, Bank of America and Deutsche Bank. Predictions for each coming year hewed fairly closely to dollar and euro values from the previous year. Other than a relatively accurate December 2008 forecast, predictions of the relative value of the euro to the dollar were off by about 25 cents.

Gigerenzer and his colleagues have found that simple decision heuristics, or rules of thumb, can work better than complex calculations when navigating uncertain domains. Distributing money evenly among available investment options, for instance, yields more money over the long haul than complex formulas for maximizing profits and minimizing losses (SN: 6/4/11, p. 26).

Financial risk modelers at the meeting acknowledged past failures of their mathematical creations but described efforts to strengthen the current approach. Economist Brenda González-Hermosillo of the International Monetary Fund in Washington, D.C., said that she and her colleagues are developing a statistical toolkit to predict upcoming financial crises based on complex analyses of currency exchange rates, money movements across countries and other factors.

Gigerenzer lamented that approach. “We need to have the courage to look for robust, simple solutions that can strengthen a fragile financial system,” he said.

Gigerenzer is now working with economists at the Bank of England to develop a three-step decision tree to assess current financial risks and dangers, as opposed to traditional measures that calculate financial risks from multiple data sources.

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